Takeaways
- HELOCs are second mortgages you take out against your home’s equity value.
- Home equity is the difference between your home’s market value and mortgage balance.
- Minimum home equity values range from 15% to 20% to be eligible for a HELOC.
- HELOCs are a revolving line of credit homeowners can tap as needed.
- HELOC drawdowns can pay for home renovations, medical bills, college education, and other significant expenses.
Buying your first home is often the marker of a financial transformation. Homeowners almost immediately start building their net worth after you begin making payments. These payments, in combination with rising real estate valuations, can generate tremendous wealth. A HELOC lets you access that capital.
Homeowners needing access to cash can tap into the wealth you have created through your equity. A home equity line of credit allows you to tap the equity in your home to access a revolving credit line.
What Is a Home Equity Line of Credit (HELOC)?
A home equity line of credit (HELOC) is a type of revolving credit line that allows homeowners to borrow money against the equity they have built up in their home. Equity is the difference between your home’s market value and the remaining balance on the property’s mortgage.
Your HELOC is effectively a second mortgage that gives you access to a pool of capital for a defined period. How much you use your HELOC is up to you. However, the maximum amount of your HELCO is determined by the market value of your home, how much home equity you have, and your creditworthiness. When you get a home equity line of credit, you are approved for a maximum limit and can draw down on that line of credit as needed.
Most people apply for a HELOC to get access to cash to pay for large bills, like:
- Medical expenses
- Educational costs
- Remodeling expenses
- Debt Consolidation
- Renovation costs
With a HELOC, you can withdraw cash from your line of credit as needed. Many homeowners prefer this method because it is cheaper than interest-debt, such as credit cards. A HELOC comes with lower interest rates than an unsecured credit line, like a personal loan, because your home acts as collateral for the line of credit.
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How a HELOC Works
A home equity line of credit (HELOC) works much like a personal line of credit (PLOC), except your house acts as collateral. You can borrow funds up to your maximum HELOC amount at your convenience. Like with a PLOC or credit card, you must pay back your balance with interest.
Every home equity line of credit has its nuances based on your personal finances, but they will all have two distinct phases: the draw period and the repayment period.
- Draw Period: You can borrow from your HELOC up to your maximum limit during the draw period, which is usually 5 to 10 years long. You can access the funds whenever convenient.
During the draw period, you only pay interest on the amount drawn (not the maximum limit). The interest rate is usually variable, which means it will change based on market conditions. This also means your monthly payments can change over the life of the HELOC.
- Repayment Period: The repayment period begins once the draw period is over. A HELOC repayment period typically lasts 10 to 20 years. During this stage, you can no longer borrow additional funds, and you must start repaying the amount you borrowed (principal) and the corresponding interest.
Some lenders have interest-only repayment options during the draw period, but you still need to repay the entire principal during this phase.
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HELOC Requirements
You will need to meet several eligibility criteria to qualify for a home equity line of credit. Of course, these vary based on your HELOC lender but often include:
- Equity in your home. The first step in applying for a HELOC is determining how much equity you have in your home. This process begins with a home appraisal to assess your home’s market value. Most lenders have a minimum percentage ranging from 15% to 20%. If you are above this threshold, your applicant can progress.
- High Credit Scores. In addition to equity, lenders will examine your credit history and overall credit score. A higher score gives you a better chance of approval and access to more favorable terms, like a lower interest rate. In most cases, you must ensure your credit score is at least 620. Some banks and lenders set higher minimum credit score requirements to ensure quality applicants.
- Low Debt-to-Income Ratio. Even with equity in your home and high credit scores, banks will analyze your debt-to-income ratio. This is the ratio they look at when deciding how much they will lend you for your mortgage or give a soft approval with a pre-approval letter.
Your DTI is a percentage of your income used to pay debts. Banks and online lenders want to see a low DTI. For HELOCs, lenders wish to have a DTI below 43%. However, the exact ceiling varies from lender to lender.
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- Current Employment. The final step is to prove that you have a reliable source of income and steady employment. This proof of income shows the lender that you can meet the repayment obligations of the HELOC agreement. (Read more about how to Earn More Money with a Side Hustle).
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Maximum Borrowing Limits for a HELOC
The maximum amount you can borrow against your home with a home equity line of credit will be determined primarily by the percentage of equity you have in your home, the balance of your mortgage, and the specific guidelines of the lender. Lenders will usually let you borrow up to 85% of the appraised value of your home minus what you still owe on your mortgage.[1]
- HELOC Example: If your home is worth $500,000 and your current mortgage is $100,000, your lender could offer a HELOC for up to 85% of the $400,000 in equity you have, which would be roughly $340,000.
Your DTI and credit score are essential in determining your max home equity line of credit. Higher credit scores and lower debt levels will give you access to larger loans. Some lenders cap the total amount that can be loaned through a HELOC regardless of other credit factors.
Before taking out the maximum amount on your HELOC, you should consult your monthly budget to see if you can handle the new debt payments. HELOCs aren’t the only game in town. Consider other ways to get access to cash quickly.
Pros of a HELOC
HELOCs have many advantages that make them a regularly used source of financing for homeowners. Here are several pros to consider:
- Easily Accessible: With accrued equity value in your home, HELOCs are an easy way to access a line of credit. Additionally, the funds are not super restricted, which means you can use them to pay for almost anything, including renovations or remodels, like rebuilding a deck or getting a pool.
- Interest on Borrowed Funds: You only pay interest on what you borrow, so you can more easily keep costs down compared to traditional installment loans, where you would pay interest on the entire amount.
- Low Interest Rates: HELOCs are secured loans. Because of this, they tend to have lower interest rates than unsecured lines of credit because lenders assume less risk.
- Interest-Only Draw Periods: Certain home equity lines of credit offer interest-only payments during the draw period, which can help make borrowing more affordable.
- Tax Advantages: Depending on your tax situation, interest paid on a HELOC may even be tax deductible. This can be very advantageous when you are filing your taxes. (Read more about tax liability vs. tax refund).
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Cons of a HELOC
Every credit product has its drawbacks, and home equity lines of credit are no different. When considering which product to use, here are several disadvantages to be mindful of when contemplating a home equity line of credit:
- Variable Interest Rates: Budgeting can be challenging with a HELOC with a variable interest rate. If interest rates rise, your monthly payments could spike, making it more difficult to budget. Sudden interest rate increases can simply become unaffordable. Also, if you borrow a large amount during the draw period, the repayment phase could create higher monthly payments than you might realize.
- Risks Home as Collateral: Your home is the collateral securing your HELOC. If you fail to adhere to the payment schedule and default on the line of credit, the lender technically has the option to foreclose. If this happens, you could lose your property.
- Reduction in Home Equity: Because you are borrowing against your home equity, you lower your home equity with each draw from the line of credit. If home prices rise, there is usually no issue. However, if home prices turn the other direction and call, you could have negative home equity. When this happens, you owe more than the market value of your home.
Home Equity Loan vs. HELOC
A home equity loan and home equity line of credit let you borrow money against the equity in your home. Here’s how they are different:
- Home Equity Loans give you an entire lump sum at once, much like a traditional personal loan. With home equity loans, you get a fixed interest rate and set a repayment schedule. This makes budgeting super easy. Home equity loans are also better suited for one-time expenses, while HELOCs are ideal for ongoing or unpredictable expenses.
- HELOCs are a revolving line of credit. You can draw down as much as you need, up to your maximum approved limit. HELOCS tend to have fixed interest rates, although some banks offer adjustable-rate options. Most homeowners use them for ongoing or unpredictable expenses.
Smart Summary
HELOCs are lines of credit that homeowners can use to draw funds from on an as-needed basis. This gives you a flexible financing option if you must pay for significant and staggered expenses, like home renovations. HELOCs are secured against your house, which means they come with lower interest rates than unsecured credit products like a personal line of credit, personal loan, or credit cards. You should evaluate whether a HELOC or home equity loan makes more sense.
(1) The Mortgage Reports. Guide to HELOC Limits. Last Accessed January 13, 2025.
